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Amazon: Another Dell In the Making?

Both computing stocks once sported sky-high price/earnings multiples, and both have seen them come way down. But of course that’s where the similarities end.

While Apple’s valuation came down by virtue of soaring earnings, Dell’s took the more common route of a declining share price. Now Apple is the most valuable company on Earth, while Dell is just another leveraged buyout.

What made the expensive Apple of a decade ago so much the better bet than Dell?

Well, Steve Jobs for one. Also, revolutionary products. But none of those advantages would have much helped shareholders without another, underappreciated edge. In 2003, when its trailing price/earnings ratio stood well above 100, Apple had all of $6.2 billion in annual revenue and roughly 3% of the U.S. PC market. Meanwhile, Dell had the ostensibly cheaper stock with a trailing p/e of about 35, $35 billion in annual revenue and a market share above 30%, tops among domestic PC makers. In other words, it had a much shorter runway than Apple.

Now look at those numbers again and guess where Amazon fits in today. This is a company with $61 billion in annual revenue, accounting for more than 15% of U.S. online sales. That’s basically your vintage 2003 Dell. The one way in which Amazon is more like the 2003 Apple is in the lofty multiple its shares fetch, at some 180 times this year’s projected earnings. So this is already a jumbo jet attempting to take off from an aircraft carrier. The chances of this ending well for passengers are low.

That’s far from the consensus at the moment. Amazon shares, triple-digit p/e and all, are up 42% in the last year despite the recent profit-taking. Meanwhile, Apple’s stock is right back where it was a year ago after giving up spectacular gains in equally spectacular fashion.

And because we’re all about instant gratification these days, we tend to tailor our theories to the most recent data point. So Apple shares got killed last month after its $13.1 billion quarterly profit was found wanting, while Amazon’s bounced after it earned all of $97 million. This was explained away with arguments about Amazon’s bright future and claims that Apple must be nearly at the end of its rope.

To back up those theories, a lot of really smart people started citing a November blog post by Eugene Wei, a former Amazon executive. Wei is a brilliant business analyst and his post sheds much useful light on Amazon’s history of operational brilliance and the advantages of its cutthroat pricing strategy.

But what people really seem to have dug is his argument that “an incumbent with high margins, especially in technology, is like a deer that wears a bull’s-eye on its flank.” Presto: there’s your explanation for the slump in Apple’s share price.

Well, yes: high-margin businesses are competition magnets, just like vaults full of cash must be guarded from looters. In contrast, if there’s nothing in your house worth stealing, you’re free to leave the front door wide open and try to loot someone else’s bank vault, I suppose. As a shareholder, however, give me the well-stuffed vault over the talented and hungry looter.

Will Amazon continue disrupting bricks-and-mortar merchants? Absolutely. Though it’s already the dominant e-tailer, online sales still account for barely 5% of the U.S. total, and are still growing at least three times faster. So Amazon’s revenue, currently up 23% year-over-year, may continue expanding nicely for a while.

But the runway will continue to shorten. The neighborhood booksellers are now largely gone, and the depleted competition in electronics may soon follow them into oblivion. Those low-hanging fruit have either already been picked or will be soon. To keep up the growth pace, Amazon will have to keep finding new markets to squeeze, be they in content streaming or electronic payments.

And let’s assume it will find them and masterfully squeeze them, applying its current low-margin strategy. Amazon would then become an even larger company, but still not a particularly profitable one.

Say it quintuples its most recent profit one day soon. That would match the $492 million earned in the most recent quarter by hard-drive maker Seagate Technology (Nasdaq: STX). Except that Seagate is valued at $12 billion, not $121 billion like Amazon.

So the only acceptable long-term outcome for Amazon shareholders is not merely the conquest of new markets but their ruthless exploitation to finally deliver all the profits the company has been deferring. At some point, either the negligible profit margins must soar or the share price must drop. But does Amazon even know how to raise margins, and could it do so if it tried? I think not.

For all the loyalty Amazon has earned from satisfied customers, the barriers to entry into online sales are modest. Thousands of retailers successfully ship products to customers’ doorstep. Scores of retailers have warehouses all over the country. None of this is exactly rocket science any longer.

So all Amazon needs to do to justify its sky-high valuation is to keep finding new markets, squeeze out competitors and then successfully raise prices like it’s never tried to do, and preferably without provoking renewed competition. That seems like a dubious proposition.

There have been plenty of high-multiple stocks that have worked out, but none that I can think of that started with a earnings yield of less than 1% and a valuation above $100 billion. Maybe Amazon will be the first. More likely, it will succumb to the laws of gravity and large numbers. And when it does, the price paid by the shareholders will be brutal.

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Best part for melistening to all the “pros” talk about how wonderful AMZN is at 4000PE is listening to the same people trash Apple at 7PE xcash when they after selling 75 million devices and taking home $13 billion in profits last quarter get smashed cause that wasn’t enough while AMZN turns in worse numbers yr over yr but “pros” looooove their “operating income”and it takes off again As good as CAT story missing earnings by 55% warning going forward and they up 22% since mid Nov. Jon Stewart should be in charge of CNBC(Ive always suspected he was but that’s just me)

It is obvious that Amazon can only do low margins despite its big earnings for one reason – it is just another retailer (no product of its own, huge shipping cost, its tax advantage is gone after change in California law).

It’s market will be shrinking when the big retailers like Wallmart, Sears, Home Depot, etc., can pick up the online business by giving freight away.

I have cancelled my Amazon prime membership when I realized that it is cheaper to buy from Wallmart, Sears and Home Depot online with free shipping.

This one item might be a “tell” that Amazon has pretty much run out of runway in the physical books segment:

“..our physical book sales experienced the lowest December growth rate in our 17 years as a book seller, up just 5%.” : Amazon 4Q2012 earnings press release. This while boasting about how after 5 years eBooks are now a multi-Billion dollar category and grew 70% last year.

And paradoxically, Amazon’s success with eBooks might well be its Achilles heel and undermine its absolute dominance of the entire books segment notwithstanding it efforts to build a moat with its proprietary kindle format.

The logistics for eBook distribution is much easier than for the physical version where Amazon managed to smother its B&M competitors. What is there to stop publishers from “disintermediating” middlemen like Apple, B&N and Amazon? Why bother with agency model, wholesale model etc. when all that is needed is a platform to host the content, manage DRM, process payment and advertise/promote etc..

This week three publishers, Simon & Schuster, Penguin and Hachette smarting from the ebook anti-trust fiasco, announced their collaborative platform, Bookish.com to claw back control. While ostensibly “not trying to steal sales” from Amazon & other retailers, you can buy direct and the ebooks sold directly use the open format, ePub.

I think publishers in time might want to reset their relationship with platforms like Amazon and Google as merely advertising and referral affiliates. And another logical next step would be to offer a subsidized generic eInk reader supporting something like a Webkit open browser and break themselves and their readers out of the Kindle and Nook walled gardens

I have worked for both companies over the last 15 years and can say that Dell and Amazon are nothing alike. The management team at Amazon (starting with Jeff Bezos) is heads and shoulders above Dell’s. Where Dell’s management was solely focused on the current quarter profits, Amazon is looking a decade + out, while continually building an ever wider kingdom and moat. Second (and just as important), Amazon knows how to innovate. Michael Dell had a great idea back in the 80′s when he started to direct market computers… but the innovation (for the most part) stopped there.

Case in point… cloud computing. About ten years ago cloud computing was in its infancy but many IT professionals saw the potential. If you asked the question back then, “who would be the tip of the spear of innovating and leading in this industry, Dell or Amazon (the online bookstore)?” Nobody would have chosen Amazon. But that is exactly when Jeff Bezos and his executive team were contemplating launching AWS.

At the end of the day, Dell was a one trick pony and Amazon continues to prove they are not. That is why their PE is so much higher than most other companies.

I have worked for both companies over the last 15 years and can say that Dell and Amazon are nothing alike. The management team at Amazon (starting with Jeff Bezos) is heads and shoulders above Dell’s. Where Dell’s management was solely focused on the current quarter profits, Amazon is looking a decade + out, while continually building an ever wider kingdom and moat. Second (and just as important), Amazon knows how to innovate. Michael Dell had a great idea back in the 80′s when he started to direct market computers… but the innovation (for the most part) stopped there.

Case in point… cloud computing. About ten years ago cloud computing was in its infancy but many IT professionals saw the potential. If you asked the question back then, “who would be the tip of the spear of innovating and leading in this industry, Dell or Amazon (the online bookstore)?” Nobody would have chosen Amazon. But that is exactly when Jeff Bezos and his executive team were contemplating launching AWS.

At the end of the day, Dell was a one trick pony and Amazon continues to prove they are not. That is why their PE is so much higher than most other companies.

I appreciate the thinking it just doesn’t seem convincing enough because your entire prosthesis is flawed. The reason for Dell’s decline or Apple’s rise is not large numbers but innovation. Michael Dell himself admitted that he didn’t see tablets being adopted at this pace. Till Amazon is innovating continuously (like Kindle and other services) I don’t think it is going down the way Apple did just recently or Dell went a year ago. Barriers to entry in most businesses are very low these days, Kickstarter campaigns and other mediums of growth lead us to enter an market very easily but that is the reason big companies like Amazon, Apple buy smaller start-ups because they know they failed to innovate and left the space for a new guy.

And with regard to the misuse of the Law of Large Numbers, you far from alone. Analysts and commentators toss this around incorrectly all the time. The NY Times ran a prominent piece a year ago (http://www.nytimes.com/2012/02/25/business/apple-confronts-the-law-of-large-numbers-common-sense.html?pagewanted=all) where the author went as far as to assert, “the law states that a variable will revert to a mean over a large sample of results.” That part of the LoLN is somewhat correct, though imprecisely stated. And the imprecision then lead the author to continue, “In the case of the largest companies, it suggests that high earnings growth and a rapid rise in share price will slow as those companies grow ever larger. ” Which is utter nonsense. The LoLN is about repeating the same experiment over and over. How do you do that with a company and life? The probability of a coin toss resulting in heads is 50%. You may flip a coin 4 times and get 4 heads, but as you repeat that toss a large number of times, the portion of heads will converge to 50%.